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Total Number of Subscribers: 426 |
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Date: 2 April 2008 |
Compiled by M. Sathya Kumar |
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How taxes affect your ESOP gains ? What happens when you mix corporate planning with financial
wizardry and HR strategy. The result is employee stock
option plans (Esops). Esops, under which key employees are offered equity shares of
their company as an incentive to remain in the company, have been used
extensively by the IT industry to attract and retain talent. However, Budget 2007 upset the apple cart of the industry when
it was announced that Esops offered by a company would be sub -ject to Fringe
Benefit Tax (FBT).
Though corporate houses have more or less reconciled themselves
to this reality, there is still a lot of confusion about the implications of
the new rule among employees. Let us understand the modalities of a basic Esop,
the tax implications prior to the recent amendment in the Income Tax Act,
1961 and the tax laws as they now stand. The laws governing Esops have been modified several times in the
past two decades. Starting 1 April 1999, employees were taxed on the difference
between the exercise price and fair market value (explained later) of shares
as on the date of exercise. The difference was treated as a “perquisite” and was included in the salary income for tax
purposes. Also, employees were taxed on capital gains arising at the time
of sale of shares on the difference between the sale price and fair market
value (FMV) on the date of exercise of the option. This resulted in double
taxation in the hands of the employees. For simplifying the system and enforcing a single stage tax
mechanism, the central government amended the tax laws with effect from 1
April 2000 to tax Esops only at the time of sale as capital gains.
Accordingly, there was no case for a perquisite being paid to the employee at
the time of exercise of stock options if these complied with the central
government’s guidelines (also generally
referred to as Qualified Esops). However, employees were subjected to capital
gains tax at the time of sale of shares. For non-compliant Esops the double
tax incidence continued. What happens now? The amendments introduced by the Finance Act,
2007, have shifted the focus from employee taxation to employer taxation, as
Esops now fall within the ambit of the FBT. The shares allotted to an
employee post 1 April 2007, under Esops will now be treated as a fringe
benefit offered to the employee by the company. Therefore, the employer will be liable to pay FBT on the
difference between the FMV of the shares on the date of vesting and amount
recovered from the employee. The FBT rate on this difference is the normal
corporate tax rate of 33.99%. Even if the options have been granted earlier,
they would attract FBT if shares are allotted on or after 1 April 2007.
Computing
fair market value How does one determine the FMV of shares allotted under Esops. The
Central Board of Direct Taxes (CBDT) guidelines say that if the company’s shares are listed on a recognised stock exchange, the FMV
would be the average of the opening and closing price of the share on the
vesting date. In case the shares are listed on more than one exchange, the
price on the bourse which records the highest volume in that share on that
date will be considered. If there is no trading in the share on any recognised stock
exchange on the date of vesting of option, the FMV shall be the closing price
on a date closest to the date of vesting of option and immediately preceding
such date on the exchange. In case shares are listed on more than one bourse, the exchange
with the highest volume in that share on that date will be considered. In case
on the date of vesting of options, the share is not listed on a recognised
stock exchange, the FMV shall be the value as determined by a category 1
merchant banker. No specific valuation methodology has been prescribed for
this purpose. But if your employer has to bear the FBT obligations, why should
you as an employee worry? The reason is simple. The tax laws specifically
provide that an employer can recover the FBT from the employee. This can be
done by tweaking the employee’s compensation package.
This is explained through an example on the following page (see box: How FBT is
calculated).
Tax
on profits from sale Employees will be subject to capital gains tax upon sale of shares.
In those cases, where FBT has been paid, the capital gain will be the
difference between the sale consideration and the FMV as on the date of
vesting of the option (this will be treated as the cost of acquisition). If shares are held for more than a year, then the capital gains
arising on sale are long-term capital gains. Long-term capital gains are tax
exempt if the transaction is routed through a recognised stock exchange and
securities transaction tax (STT) has been paid on the sale. Assuming that the
employee sells the shares allotted on 26 December 2008 after holding for a
year on 25 January 2010 and pays STT, he will not have to pay any tax on the
profits made. If no STT is paid, long-term capital gains would be taxed at 20%
(plus applicable surcharge and edu -cation cess) and benefit of indexa -tion
on cost of acquisition would be available. Alternatively, one can choose to
pay long-term capital gains at 10% (plus applicable surcharge and education
cess) on the capital gain computed without indexation benefit. But, if shares are held for less than one year from allotment,
the resulting short-term capital gain will be taxed at 10% (plus surcharge
and education cess), if STT has been paid upon sale. In other cases,
short-term capital gains would be taxed at 30% (plus the applicable surcharge
and education cess). This tax will need to be paid either as advance tax by the
employee concerned directly or he or she can disclose such capital gains to
the employer and authorise that tax be withheld from salary income after
taking into consideration the additional taxable capital gains component. For employers the recently introduced notification which lays
down the criteria for determination of FMV is not free from ambiguity. For
instance, if the employer company is not listed in India, or the Esops of the
global parent or foreign affiliate cover the employees of their subsidiaries
in India, only a category 1 merchant banker can be engaged to determine the
FMV of the shares granted under the plan. No valuation guidelines have been
prescribed in such cases. This could result in tax litigation in the future. However, it should be remembered that while the FBT burden can
be passed on to the employee, the employee will not have to face any
litigation related to the fringe benefit tax. |
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